China 1Q GDP: Reaching the Bottom

We expect Beijing to continue stepping up easing efforts through another 100bp RRR cuts, open market operations, tax breaks and fiscal spending on public works in 2Q.

China’s 1Q GDP growth cooled to 8.1% y-o-y from 8.9% in 4Q, close to our
expectations of 8% but below consensus of 8.4%. The annualized sequential growth
dropped to 7.2%, the lowest level since 4Q 2008. The weakening number calls for
more policy easing, and slowing inflation leaves room for easing. We expect
Beijing to continue stepping up easing efforts through another 100bp RRR cuts,
open market operations, tax breaks and fiscal spending on public works in 2Q.
Once these measures filter through, GDP growth should bottom out in 2Q and
recover to over 8.5% in 2H. Our 8.6% GDP projection for 2012 remains intact.

Facts China’s economic growth slowed sharply to 8.1%
y-o-y in 1Q from 8.9% y-o-y in 4Q, roughly in line with our expectation (8%) but
well below market expectations (8.4%). The q-o-q seasonally adjusted annualized
rate dropped to 7.2% in 1Q from 8% in 4Q, the lowest level since 4Q 2008 (3.7%
by our estimate). By sector, the growth slowdown is board-based in 1Q: the
growth of primary industries slowed to 3.8% from 4.5% y-o-y in 2011 while
secondary industries and tertiary industries saw a sharper slowdown to 9.1%
y-o-y and 7.5% y-o-y respectively (vs. 10.6% y-o-y and 8.9% y-o-y in 2011).

March growth data confirmed the ongoing slowdown of investment, despite the
small upside surprise with industrial production (IP) growth. IP growth edged up
to 11.9% y-o-y from 11.4% y-o-y in Jan-Feb, beating our and consensus forecast
(Bloomberg: 11.6%, HSBC 11.3%). This translated into a higher m-o-m sa growth at
1.22% in March, from 0.84% m-o-m in February. The rebound was mainly led by
light industries, whose growth accelerated to 13.9% y-o-y in March from 12.7%
y-o-y in Jan-Feb. Meanwhile, growth for heavy industries only edged up to 11.2%
y-o-y in March from 10.9% y-o-y in Jan-Feb. Volume growth of major industrial
products only saw modest improvement: electricity growth edged up marginally to
7.2% y-o-y compared with 7.1% y-o-y in Jan-Feb; steel production rose to 10.2%
y-o-y from 4.6% y-o-y in Jan-Feb and cement production improved to 7.9% y-o-y
from 4.8% y-o-y in Jan-Feb, cars production expanded by 5.1% y-o-y in March,
reversing the 1.8% contraction in Jan-Feb. However, crude oil production growth
dropped to 2% y-o-y from 4% y-o-y in Jan-Feb.

Fixed asset investment growth (FAI) slowed to 20.9% in 1Q from 21.5% y-o-y in
Jan-Feb period, a touch lower than market expectations of a slowdown to 21%
y-o-y. This means that March’s FAI growth fell to 20.5% y-o-y and 0.64% m-o-m sa
(only one third of the pace at 1.91% m-o-m in February). Investment at local
levels cooled to 23.1% y-o-y in March from 24% y-o-y in Jan-Feb while investment
backed by central government saw a sharper contraction at 9.7% y-o-y in March
compared with the decline of 7.9% y-o-y in Jan-Feb.

By sectors, investment growth slowdown was led by tertiary sectors (17.6%
y-o-y in 1Q from 18.5% y-o-y in Jan-Feb) while growth of investment in primary
and secondary sectors also cooled to 35.8% y-o-y and 24.6% y-o-y respectively in
1Q (from 43.9% y-o-y and 24.9% y-o-y respectively in Jan-Feb).

Real estate investment decelerated sharply to 23.5% y-o-y in 1Q from 27.8%
y-o-y in Jan-Feb, implying March’s single month growth dropped sharply to 19.5%
y-o-y. This is mainly due to the slowdown of ongoing projects, whose
construction floor space fell to 25% y-o-y in 1Q compared with 35.5% y-o-y in
the first two months. Meanwhile, floor space of new housing projects stayed
almost flat at 0.3% y-o-y in March, compared with by 5% y-o-y in Jan-Feb.

Retail sales growth picked up to 15.2% y-o-y in March from 14.7% y-o-y in
Jan-Feb, slightly better than market and our expectations (Bloomberg: 15.1%,
HSBC: 14.8%). Real growth of retail sales rose to 11.3% y-o-y in March from
10.8% in Jan-Feb. The seasonally adjusted m-o-m growth moderated to 1.18% in
March from 1.31% in February. Breakdown suggests improvement with food and
closing, and home appliances (likely attributed to the better property sales in
March). However, car sales dropped to 8.1% y-o-y from 12.7% in
Jan-Feb.

Implications: Today’s disappointing GDP print, coupled
with the release of trade and inflation numbers earlier this week, confirmed
that China’s growth is still slowing at a face faster than expected. Although
March’s strong new lending suggested the earlier easing measures started
working, we continue to believe that growth slowdown remains the major policy
concern. We still see challenges ahead on both external and domestic fronts:

- Manufacturing sectors slowed notably due to the deceleration of exports
and investment growth. IP growth dropped to 11.6% in 1Q from 12.8% in 4Q, while
exports dropped to 7.6% y-o-y in 1Q, the lowest reading since 2009 and only a
half of the pace in 4Q. The latest HSBC manufacturing PMI dipped to a four-month
and stayed below 50 no-change level in five consecutive months. Coastal regions
and small companies are in difficult conditions.

- Exports-led slowdown started to slacken job growth and slow wage growth in
manufacturing sectors (as indicated by the employment components with HSBC
PMIs), though the overall job market remains stable. Since small and medium
sized companies absorb around 70% of employment, their vulnerability to further
exports and growth slowdown (if materialized) is likely to further weigh on job
market.

- Property correction just started and its impact is likely to be fully
unfolded in the coming months. Despite the improvement of March property sales,
further slowdown of property investment is likely as indicated by slowing new
and ongoing property construction floor space, as well the falling land
purchases.

Going forward, we believe Beijing should and will continue to step up easing
efforts in the following areas:

- Monetary easing via additional 100bp RRR cuts and capital injection in open
market operation in 2Q, and a likely 25p rate cut towards the end of 2Q. Despite
the rebound of March’s new lending, the current M2 growth remains well below the
level of 13.6% at end last year and 14% official target for this year.

- Fiscal easing via additional tax breaks (especially for small companies)
and fiscal spending on public works. Clearly with over RMB3trn cash deposits,
Beijing has sufficient fiscal power to support growth and employment.

- Deregulation on private investment to participate in a wider range of
sectors. This should break monopoly in some sectors and improve the investment
efficiency. If detailed measures to be delivered in the coming months (as
Premier Wen committed at NPC), this should become an effective boost to
investment growth.

Once these measures gradually filter through, we expect the GDP growth to
start bottom out in 2Q and recovery modestly to over 8.5% y-o-y in 2H. Our 2012
full year GDP growth forecast of 8.6% remains intact.

Bottom line: Growth came in weaker than expected and remains
the key policy concern. This, plus the outlook of easing inflation, implies that
Beijing should and will step up additional easing measures. Once filtering
through, Chinese economy should start to bottom out in 2Q and grow around 8.6%
y-o-y in 2012.

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